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Foreign Banks Stock Outlook - Feb 2013 - Industry Outlook

In order to plan the path to future growth, banks all over the
world are seeking new strategies to lessen the regulatory burden.
Almost every bank has its focus on capital efficiency. And most of
the foreign banks are adopting reconstruction-by-asset-sale
strategies to strengthen their capital ratios.

Self-protective efforts are significantly helping these banks to
stay afloat, though at the cost of moderating top and bottom-line
growth. Moreover, the industry remains thwarted by non-stop
challenges that are keeping its performance muted.

The latest deterrents, nagging macroeconomic issues -- the European
sovereign debt crisis in particular -- and regulatory pressures,
are continuously taking a toll on the financials of many banks,
resulting in the sector's underperformance.

As growth remains the primary focus of central banks, interest
rates are not expected to increase at least in the next couple of
years as inflation is not a major concern for most of the countries
other than a few emerging economies. Thus, banks operating in a low
interest rate environment will not be able boost revenue through
interest income. On the other hand, non-interest revenue sources
will be limited by regulatory restrictions.

Banks in emerging economies will, however, not face significant
challenges related to interest income due to a not-too-low interest
rate environment. Anti-inflationary measures of the central banks
of these economies are expected to keep interest rates high.
However, non-interest revenue challenges will persist.

Complying with stringent regulation is not a major concern for most
of the banks, but it would be difficult to optimize business
investments in the way banks run their businesses. So banks will
need to reassess and restructure their operating models to be
successful, which will take considerable time.

The Recent Past and Near Future

Despite a number of high-profile scandals, many of the world's
largest banks were able to gain investors' confidence in 2012 as
reflected by their share price performance. Many foreign banks,
including giants like
UBS AG
(
UBS
),
Barclays PLC
(
BCS
) and
HSBC Holdings plc
(
HBC
), ended the year with substantially higher share prices compared
to the beginning of the year. Also, the MSCI World Bank Index
increased more than 20% in 2012.

However, with respect to the financial health, less resilience was
seen during the year than was anticipated. Growing challenges
related to funding, still-high costs despite belt-tightening
through layoffs and limited access to revenue sources kept
bottom-line growth under pressure.

The upcoming quarters don't look any better, with several negatives
hampering the sector like asset-quality troubles, high borrowing
costs, steeper expenses and weak loan demand. But thanks to
worldwide regulatory reform, the sector has at least entered a
transformation phase with the restructuring efforts in place.
Needless to mention, an essence of growth has yet to be felt.

On the Fundamental Side

Looking at the fundamentals, a rising risk-aversion tendency has
still kept client activity slowed, resulting in weak trading
volumes and subdued credit demand. Also, learning from past
experience, banks are now more cautious about lending money.

Consequently, lower business activities and anticipated subdued
profitability are making foreign banks less appealing to investors.
Valuation multiples of these banks will continue to reflect the
fundamental challenges at least through the first half of 2013.

The growth potential of some non-U.S. banks could be restrained by
higher reserve requirements and outsized losses related to capital
markets. But strict lending limits as part of the regulatory
overhaul as well as greater transparency in regulations could
strengthen the fundamentals of many sector participants.
Eventually, these are expected to create a less risky lane for the
overall industry.

As inter-country investment walls have fallen, some large non-U.S.
banks are freely expanding beyond their domestic boundaries through
mergers and acquisitions to utilize regional regulatory benefits.
On the other hand, regulatory pressure to focus more on the home
market is forcing some global banking giants to sell overseas
assets. Accordingly, banks are trying hard to restructure their
operating models and address funding needs.

While the sector saw a moderate recovery in 2010, the performance
in 2011 was among the poorest in its history. Then in 2012, the
industry came across a number of new difficulties. But a
risk-averse approach helped it perform better than 2011.

Primary Headwinds

The primary headwind for global banks is regulatory pressure, which
ensued from taxpayers' money and government intervention that banks
have relied on in order to remain in business. Regulatory reform is
a key issue for banks over the last few years. The impact of
regulations has yet to be fully felt with many rules still
impending.

Moreover, government efforts to alleviate industry concerns have
significantly raised political debates over time. Politics will
continue to influence lending decisions as long as banks remain
financially dependent on governments. According to banking
regulators, if governments withdraw their support from banks before
giving them sufficient time to restore their financial strength,
the sector could collapse again. The need for bailouts is still
felt acutely by the European banks.

Adding to the concern is the tendency of regulators worldwide to
agree on common minimum standards to prevent the recurrence of a
global financial crisis and restore public confidence. The
introduction of Basel III standards is a case in point.

With these regulatory measures, the individual capital structure of
banks will remain under constant pressure. Also, the efforts to
develop new business models will become much more expensive and
difficult. However, the resulting slowdown at some big banks could
be seen as a blessing in disguise, as it would eventually make
their balance sheets more recession-proof and provide a new set of
opportunities.

Valuations Look Attractive

Balance sheet repair and credit environment recovery will make the
valuations of some non-U.S. banks attractive going forward.
Particularly, valuations of the mega banks, which could comfortably
maintain the minimum capital norms mandated by the Basel Committee,
will experience the fastest valuation upside. Consequently, we
believe this would be a good time for long-term investors to
consider foreign bank stocks, as the valuations at present look
comparatively cheaper.

Investors with short-term targets, however, should be watchful
while choosing foreign bank stocks at this point as near-term
fundamentals do not look promising. Asset quality lacks the
potential to a rebound anytime soon as default rates for
individuals and companies are not expected to materially subside,
and revenue growth might remain weak with faltering loan growth and
a low interest rate environment in most of the countries.

If any improvement occurs in the near-to-mid term, it will vary
from country to country, depending on industry circumstances.

Ratings Concerns

Rating downgrades remained a major threat for major global banks in
2012. Lingering macroeconomic issues and sovereign crises across
Europe dampened the credit profile of many banks to a notable
extent. This prompted the rating agencies to take negative rating
actions on these banks during the year.

In July 2012, Moody's Investors Service, the rating arm of
Moody's Corp.
(
MCO
), downgraded credit ratings of 15 systematically important banks
in the U.S., U.K. and Europe. The downgrade was based on the
agency's concern related to these banks' significant exposure to
the volatility and expected losses from capital market activities.

In October 2012, Standard and Poor's (S&P) downgraded three
French banks due to rock-bottom French consumer confidence.

However, Moody's, in its global banking outlook for 2013, stated
that the ratings of global banks are expected to be relatively
stable. The rating agency will keep an eye on excessive risk-taking
by banks to offset the negative effects of low interest rates,
elevated sovereign risk for the European banks and impacts of
regulatory reforms.

Eurozone Woes

European banks are expected to underperform in the upcoming
quarters due to increasing capital pressure emanating from the
ongoing debt crisis in the region.

Though the funding situation in Europe has improved to some extent
backed by huge aids from the European Central Bank, there remain
deep concerns related to the banks' ability to meet capital
requirements.

Italy and Spain showed signs of improvement with support from the
government and European Central Bank, but conditions in Greece
remain uncertain due to issues related to additional bailout funds.

European policymakers have taken a number of important steps
including the purchase of government bonds by European Central
Bank. These actions have helped the European markets to stabilize
to some extent. However, the policymakers need to take additional
steps to alleviate investor panic and restore confidence.
Otherwise, the risk of a credit crunch will deepen further.

Overall, the European Union is trying hard to restore investor
confidence as well as fundamentally reshape the continent's banking
system. The issue, however, remains far from being addressed.

Emerging Markets

Coming to the banks in emerging economies, the asset quality
trouble is obvious. However, these are not plagued by other serious
problems that many of the larger banks face in continental Europe
and the United Kingdom, such as toxic securities and dilution from
capital raising. Moreover, these emerging-market banks generally
tend to be well capitalized, aren't as heavily exposed to property
markets, and have significant and growing sources of non-interest
income.

We believe that banks in emerging economies -- Chile, Brazil and
India -- look more attractive, akin to certain regional banks in
the U.S., Australia and Canada that have capital strength, good
funding and growth potential.

Conclusion

Overall, a key determinant for a quick recovery will be the quality
of risk analysis and risk awareness in decision making and
incentive policies. So, we believe that accumulating larger capital
buffers over the cycle and reducing pointless complexity in
business will be crucial to banking performances.

Also, only cost reduction by job cuts and asset sales is no longer
considered enough. Instead, the aim should be to enhance
operational efficiency through fundamental changes in business
models. The capital goal of global banks should be more than just
complying with regulatory requirements. Banks need to reshape their
operating models to convert regulatory mandates to opportunities.

On the other hand, the primary attention of policymakers should be
on determining the span of fiscal stimulus, ensuring that it
remains till a clear sign of transition from recovery to growth is
visible.

We would suggest avoiding European banks at this point, including
banks in Great Britain and Ireland. The weaker banks are those that
have participated in government recapitalization programs and are
yet to repay. In return of government capital and asset quality
protection, these banks are facing regulatory intervention, like
enforcing limits on dividend payouts and board member nominations.

Currently, the only bank we dislike with a Zacks Rank #5 (Strong
Sell) is
Erste Group Bank AG
(
EBKDY
).

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